February 24, 2014

Is more financial stability possible?

The RoE (Return on Equity), an internal performance measure of shareholder value was a wrong financial performance measure. Since RoE is the most well-known performance indicator widely used by market participants and banks themselves in their disclosures (i.e. at the top line of bank reports), targeting RoE has exposed banks to higher unexpected risk levels and opened the door to a more shortterm- oriented approach to balance sheet management. This ratio was not adjusted for the risks that financial institutions are taking, i.e. leverage funding and liquidity profile.
Policies, including Basel I, have encouraged regulatory arbitrage. Reduced capital ratio minimums incentivized banks to increase leverage and a significant reduction in reserve requirements in the 1990s, precipitated lower liquidity and higher leverage. This created the conditions for a financial crisis we are facing today.

In the years 2002–06 before the crisis, profits were high but several large banks required bailouts. Banks increased profits through both balance sheet and off-balance-sheet growth and by taking on riskier asset/liability mismatches.

1. Return on Equity (RoE):
Return on Equity is the primary measure banks have pursued to evaluate their performance. RoE used to be very convenient for bankers. The bank board was given a target RoE which they could achieve in one or two ways: they could increase the returns or hold the equity low in the RoE measures. In the banking business they did both at the same time, high returns and equity low.

     RoE = net income / average total equity

Since mid-90’s the banking sector was underperforming the utility sector and was not serving the investors very well. It has bankers let to keep equity to a minimum and made them vulnerable as enterprises and has made the whole financial system very fragile.
What are proper ways to value the banks? What are the measures bank management and investors should be focusing on?
If bankers continue to pursue the target RoE they should wait for a longer period of years of time to measure if they have hit the target or not and to reward themselves. If they don’t wait this period for the consequences of the risks taking with the equity they are given. Than they need to adopt intra measures that are risk adjusted.

2. Return on Assets (RoA):

Return on Assets (RoA) is a basic measure of bank profitability that corrects for the size of the bank.

     RoA =   net income / average total assets

3. Return on Risk-Weighted Assets (RoRWA):

By introducing the measure Return on Risk-Weighted Assets (RoRWA) the boards and executive management needs to focus on the issue of risks. What risks are banks taking, what order of magnitude, what are the potential outcomes, in which area. These risk weights come out of Basel regulations, exposure against which they are measured are generated by the banks themselves. Since the crisis there are new Basel regulations, Basel III which is an improved version of Basel II/2.5. Now also capital and liquidity requirements, including the Tier I capital leverage ratio, liquidity coverage ratio, and the net stable funding ratio are primary measures of a bank.

But are these Basel-driven risk weightings right? Does a bank board need to judge these weightings themselves? Which other measures do we need to take into account to let banks better perform than in the past? The RoE was the primary measure of many banks which they pursued in terms of the profitability objective, the capacity to generate sustainable profitability. We have seen that it has not contributed to long-term shareholder value. Instead it has contributed to volatility of returns, excessive leverage, risk-taking which has made our financial system very unstable. This has encouraged the banks to keep the equity small as possible and the leverage as large as possible and has made the financial system fragile. Today, it is very important to promote financial stability. We have to create well regulated banks that are more prudent. It means more equity in the mix and having the right targets to encourage them.

We are investigating how the RoE changed before, during and after the crisis. What are the main drivers explaining the RoE changes over the crisis? What are appropriate performance measures after the financial crisis? Are the Basel regulations good policies or do need banks themselves consider other measures. Are stress testing programs imposed by Basel a good tool to supplement other risk management approaches and measures?

References :

  1. The determinants of bank capital structure. Working Paper Series. No 1096 / September 2009. European Central Bank.
  2. Beyond RoE - How to measure bank performance. September 2010. European Central Bank.

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